The repercussions of Lehman's Bankruptcy - Interest Rate Swaps, Interest Rate Caps and Credit Default Swaps.
Many of the companies we review in this forum utilize one or more of these derivative products to hedge their long term debt financing risk. A company will obtain a long term variable rate LIBOR financing facility with a separate (private party) Interest Rate Swap (or Cap) contract that allows them to "hedge" their interest rate risk out into the future.
With Lehman's bankruptcy there is going to be a lot of uncertainty and disruption to the companies that have entered into these private party agreements. These agreements are not public and are not disclosed in detail in the 10K reports.
Here is how the bankruptcy procedure proceeds for these private party agreements and an explanation of how the derivative products are un-wound and settled.
efinancialnews.com
==============================================================
Every company situation is different, but now I am evaluating my "value" holdings to determine if any are subject to potential derivative contracts (and the associated risk) they might hold.
My take away from this is that there is estimated to be some $63 Trillion of potential derivative exposure by both large and small companies. It made me realize that there are thousand of companies that hold some type of derivative financing product which if defaulted would impact current and future earnings significantly.
When evaluating the "value" proposition on any new purchases, this is one component I plan to analyze carefully.
EKS
==============================================================
Case Study - Macquarie Infrastructure Company LLC (MIC)
(Disclosure: I own a very small starter position and continue to like the company. With this most recent review, I have a better understanding of their "actual" derivative exposure.)
finance.yahoo.com
This is a company I recently bought that holds a lot of long term debt but generate a significant steady cash flow that appears to be more than sufficient to service this debt.
After looking at their most recent 10K, I have discovered that 87% of their long term debit is hedge with (one or more) Interest Rate Swap agreement(s) and I have no idea with what institutions (more than likely it is a "comingled" agreement).
Worst case is that all of their Interest Rate Swap agreements go sour (non performing by the private party principal) and the company books a $1.10/share derivative loss ($53 million exposure as stated in their 10Q).
From the most recent 10Q report (August 2008) -
investor.shareholder.com
"...At June 30, 2008, the Company had $1.5 billion of long-term debt, $1.3 billion of which was hedged with interest rate swaps, $58.7 million of which was hedged with interest rate caps, $92.6 million of which was unhedged and $6.4 million of which incurred interest at fixed rates...".
Since these are private agreements, the 10Q report does not mention which company(s) MIC has entered into these swap agreements with.
It appears that the total liability to the company if these swaps go sour is $53 million or about $1.10/share. If MIC has exposure to Lehman's default book, MIC could take a hit on earnings if their interest rate swaps are re-priced once the swap derivatives have been auctioned off in the bankruptcy.
This type of bankruptcy procedure is unprecedented and has never been tested. Here is the procedure that is supposed to be followed for settling these private party derivative transactions.
efinancialnews.com
==============================================================
MIC should survive as long as their cash flow remains strong and the LIBOR rates remain stable. The prudent thing for management to do is cut their distribution, build a contingency reserve to cover higher interest rates and work on paying down long term debt (and refinance the bulk of their variable debit into fixed terms 7-10 years out.
The net impact to the company will be a slightly higher cost of funds with little or no risk to these unfolding global debt uncertainties. The next few years will be trying times for all companies that carry a lot of debt.
EKS |
